How the Debt Tussle Can Help Move Toward a Flat Tax

Setting a fixed-percentage tax credit for itemized deductions would signal Republican sensitivity to fairness, appeal to redistributionist Democrats, and create another precedent for a flat tax.

It’s no mystery that President Obama and congressional Democrats would like to use this month’s debt ceiling talks to get Republicans to agree to raise revenue more and cut spending less. Transparent tax rate hikes are finally off the table, but the latest White House proposal is to cap itemized deductions for higher-income families with adjusted gross income of $250,000 and up, and individuals earning more than $200,000. This plan would limit the value of those deductions to 28 percent of income for those in even higher marginal income tax rate brackets, instead of the current maximum top rate of 35 percent in those income brackets.

President Obama rationalizes that, “If we choose to keep those tax breaks for millionaires and billionaires, or for hedge fund managers and corporate jet owners . . . then we’ll have to make even deeper cuts somewhere else.” Other Democrats add that high-income people unfairly benefit more from any given tax deduction than middle-class taxpayers do under current law, because the former are in higher tax brackets. But a better response to these claims would be for Republicans to help limit the distortions caused by current tax expenditures for health insurance, home mortgage, and other favored forms of “spending through the tax code”—but still without raising overall taxes.

Providing greater deductions to those who incur greater expenses to produce more income is eminently defensible.

First, let’s quietly acknowledge past misdeeds in recent fiscal history by our two political parties, best described more favorably by Jude Wanniski 35 years ago as the “Two Santa Claus Theory.” This theory contends that if one political party (the first “spending Santa Claus”) entices voters by promising more government spending, then a competing party cannot gain sufficient appeal by proposing less spending. Instead, the competing party must offer other appealing options, such as lower tax rates and the greater economic growth they can create, as a second “tax-cutting Santa Claus.” Rather than reduce the amount of revenue in order to control government spending, the goal is to finance it more attractively.

Neither this theory nor other competing ones (e.g. perpetual Keynesian stimulus, spending austerity, monetarist formulas for a steady supply of dollars, “deficits don’t matter,” and “starve the beast” tax cutting) actually hold up consistently for long under the conflicting political and economic cross-pressures of modern politics.

Like other Obama administration policy ploys, the income-based itemized deduction cap is half-baked. Although there is some merit on fairness and efficiency grounds to limit tax subsidies for consumption of goods and services like health insurance and housing—particularly for upper-income earners—the White House proposal does nothing to help lower-income Americans in return. A better balance would involve setting a single rate for such deductions, raising the deduction rate for lower-income taxpayers and lowering it for higher-income ones, until they meet at a revenue-neutral level—equivalent to a fixed-percentage tax credit for such favored expenditures that provides the same proportional “pre-tax discount” for all purchasers.

This would appeal to Democrats’ perpetual lust for income redistribution through the tax code, signal some sensitivity to fairness concerns by Republicans, and create another precedent for moving more comprehensively toward a flatter, if not flat, rate version of income tax reform. Providing greater deductions to those who incur greater expenses to produce more income is eminently defensible; handing out extra portions of tax subsidy dollars to higher-income taxpayers to consume more, and higher-priced, consumption goods and services falls short on both efficiency and equity grounds.

This incremental, flat-rate approach to reforming the tax treatment might start with health insurance and perhaps home mortgages, but it could provide a broader template for cleaning up most, if not all, of the tax expenditures.

This approach would also move future tax policy for healthcare beyond the upcoming limitations and distortions of the “Cadillac tax” on high-cost group insurance plans, as prescribed in the Patient Protection and Affordable Care Act. If that new excise tax is imposed, it would apply to the “issuers” of health insurance rather than its end users, and at a uniform 40 percent “wholesale” rate different from individual workers’ various marginal income tax rates at the “retail” level. On the other hand, the fixed-percentage tax credit approach would be more even-handed for most health insurance purchasers, and it could be applied sooner. Its level of tax subsidies for individuals and families would adjust automatically for premiums that might vary based on a purchaser’s geographic market or health-risk factors.

Of course, nothing short of completely eliminating the tax exclusion for employer-sponsored group health insurance, and related tax subsidies for other types of healthcare purchases, would remove all of the inefficiencies and distortions in health spending created and sustained by the current tax code. Nor does capping the rate at which health spending is subsidized by taxpayers set a ceiling on the absolute amount that one might receive in open-ended tax benefits (i.e., spend more on expensive insurance packages and receive larger tax subsidies). But the issue of a maximum per-capita or per-family cap on health tax subsidies could be addressed separately, along with offsetting reductions in marginal income tax rates across the board. And lowering the maximum rate at which health insurance spending can be tax-subsidized still would reduce the incentives of the most influential voices in employers’ health benefits decisions—higher-income workers and proprietors—to seek more comprehensive and expensive health insurance options.

What’s still missing here is a complementary piece of more equitable tax treatment of health spending for the self-employed. However, a recently passed, temporary short-term tax policy measure could extend to self-employed purchasers the (adjusted) subsidies of the exclusion of group health insurance benefits from predominantly flat-rate FICA payroll taxes. Under previous tax law, the self-employed never had the value of the health insurance they purchase “excluded” from their wage income subject to those payroll taxes. (The self-employed only gained the right to deduct the full value of their health insurance premium payments from federal income taxes within the last decade.) A temporary provision to do this just for calendar year 2010—primarily for short-term economic stimulus reasons—was included in the Small Business Jobs and Credit Act of 2010 by then-Democratic majorities in both houses of the previous Congress. But it expired at the end of last year and should be restored.

This incremental, flat-rate approach to reforming the tax treatment of currently subsidized consumption purchases suggested above might start with health insurance and perhaps home mortgages, but it could provide a broader template for cleaning up most, if not all, of the tax expenditures that distort relative prices and purchasing decisions—yet without raising overall taxes. It won’t solve our looming, massive public debt and uncontrolled government spending problems by itself. But it can help deflect some of the latest faux-populist political pressure to raise even more tax revenue on the “somewhat richer” and turn it into a stronger case for simpler and flatter marginal tax rates. Even the heavy lift of major debt reduction and tax reform can use a little extra leverage.

Thomas Miller is a resident fellow at the American Enterprise Institute.